The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Friday, May 24, 2013

Martin Wolf and Ken Rogoff agree: "it is not too late to change course"

The Financial Times' Martin Wolf and Harvard professor Ken Rogoff have taken different paths, but they both agree that the current approach to handling the bank solvency led global financial crisis that began on August 9, 2007 is not working and that "it is not too late to change course".

Mr. Wolf sets out in his column what would be included in this change of course.

The right approach to a crisis of this kind is to use everything: policies that strengthen the banking system; policies that increase private sector incentives to invest; expansionary monetary policies; and, last but not least, the government’s capacity to borrow and spend.

Professor Rogoff lays out in his Guardian column what he thinks is wrong with the current approach and therefore what should be included in this change of course.

No one seems to have the power to impose a sensible resolution of its peripheral countries' debt crisis. Instead of restructuring the manifestly unsustainable debt burdens of Portugal, Ireland, and Greece (the PIGs), politicians and policymakers are pushing for ever-larger bailout packages with ever-less realistic austerity conditions.

Interestingly, both Mr. Wolf and Professor Rogoff have come to champion your humble blogger's blueprint for fixing the financial crisis.

For both individuals, the starting point is dealing with the excess debt in the global financial system. As Professor Rogoff points out:

In a debt restructuring, the northern eurozone countries (including France) will see hundreds of billions of euros go up in smoke.... These hundreds of billions of euros are already lost, and the game of pretending otherwise cannot continue indefinitely....

But the sooner the underlying reality is made transparent and becomes widely recognised, the lower the long-run cost will be.

The way to deal with this excess public and private debt is by adopting the Swedish Model and requiring the banks to absorb upfront the losses on this debt.

By having the banks absorb the losses on the excess debt, the burden of servicing this debt is lifted from the real economy. Currently, capital that is needed for reinvestment, growth and supporting the social contract is being diverted to servicing this debt. Ending this diversion will boost the growth rate of the real economy.

Regular readers know that a modern banking system is designed so that the banks can absorb these losses and still continue to operate and support the real economy.

Banks can do this as a result of the combination of deposit insurance and access to central bank funding. With deposit insurance, when banks have low or negative book capital levels, taxpayers effectively become the banks' silent equity partner.

After absorbing the losses, the banks then rebuild their book capital levels through retention of 100% of pre-banker bonus earnings.

To make sure the bankers don't gamble on redemption while the banks are rebuilding their book capital levels, banks must be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details. With this information, market participants can exert discipline on the bankers to restrain risk taking.

Once the losses have been recognized, to jumpstart the economy, governments need to adopt fiscal stimulus.

At the same time, central banks need to remove the economic headwinds caused by zero interest rate policies and quantitative easing. They need to restore short term interest rates to Walter Bagehot's lower bound of 2%.

Increasing interest rates from zero to two percent is actually good for economic growth as it ends the Retirement Plan Death Spiral. Zero interest rates triggered this death spiral as savers, both individuals and companies, reduced their current consumption to offset the lack of earnings on their retirement savings.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.